What is ‘Duration’
Duration is a measure of the sensitivity of the price — the value of principal — of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years. Bond prices are said to have an inverse relationship with interest rates. Therefore, rising interest rates indicate bond prices are likely to fall, while declining interest rates indicate bond prices are likely to rise.
BREAKING DOWN ‘Duration’
The duration indicator is a complex calculation involving present value, yield, coupon, final maturity and call features. Fortunately for investors, this indicator is a standard data point provided in the presentation of comprehensive bond and bond mutual fund information. The bigger the duration, the greater the interest-rate risk or reward for bond prices.
It is a common misconception among non-professional investors that bonds and bond funds are risk free. They are not. Investors need to be aware of two main risks that can affect a bond’s investment value: credit risk (default) and interest rate risk (rate fluctuations). The duration indicator addresses the latter issue.
Usefulness of Duration
As investors consider their portfolio construction, the concept of duration enables them to compare bonds and bond funds with a variety of coupon rates and maturity dates. The expectation of interest rates rising in the future would point investors to shorter-duration bonds, which have less interest-rate risk.
Effects of Duration
Duration is measured in years. Therefore, if a fixed income security has a high duration, it indicates that investors would need to wait a long period to receive the coupon payments and principal invested. Moreover, the higher the duration, the more the fixed income security’s price would fall if there is a rise in interest rates. The opposite is true.
Normally, if interest rates change by 1%, a fixed income security’s price is likely to experience an inverse change by approximately 1% for each year of duration.
For example, assume an investor wishes to select bonds which suit her portfolio’s criteria. She believes interest rates will rise over the next three years and may consider selling the bonds prior to the maturity date. Therefore, she would need to consider the duration when investing and may wish to invest in bonds with shorter duration.
Assume an investor wishes to purchase a 15-year bond that yields 6% for $1,000 or a 10-year bond that yields 3% for $1,000. If the 15-year bond is held to maturity, the investor would receive $60 each year and would receive the $1,000 principal after 15 years. Conversely, if the 10-year bond is held until maturity, the investor would receive $30 per year and would receive the $1,000 principal invested.
Therefore, the investor would want to consider 10-year bond because the bond would only lose 7%, or (-10% + 3%), if interest rates rise by 1%. On the other hand, the 15-year bond would lose 9%, or (-15% + 6%), if rates rose by 1%. However, if interest rates fell by 1%, the 15-year bond would rise more than the 10-year bond.